Apart from booking profits and moving to cash, lately equity fund managers have also taken to using arbitrage positions or buying put options on the indices to hedge against the risk of a market fall. Typically, equity funds which take cash calls and hybrid funds such as equity-savings schemes park a portion of their portfolios in cash-futures arbitrage trades in order to hedge risks.
Given that arbitrage gains are not dependent on market directions and can be earned even in falling markets makes a part of the portfolio immune to sharp market moves. But the downside of this strategy is that arbitrage trades cannot generate equity-like returns - their returns are closer to liquid-fund returns. Therefore, there is an opportunity cost to owning big arbitrage positions in the portfolio.
A recent crop of closed-end funds have also used put options to limit losses. If you take the case of a typical three-year closed-end fund, the fund buys Nifty 50 put options with a three-year term. Now, if the Nifty falls in value by the time the fund matures, the put gains in value to compensate for the loss on the equity portfolio. If the Nifty rises, the fund forfeits the money it used to buy the puts.
An illustration provided with HDFC Equity Opportunities Fund (II) launched recently showed that the fund proposed to used 6 per cent of its assets to buy Nifty 50 put options. At a strike price of 9600, the fund will gain 22 per cent if the Nifty 50 shot up by 30 per cent over the next three years. But the fund would only lose 5.66 per cent if the Nifty 50 crashed by 30 per cent (this is assuming the fund mirrors the Nifty).
The benefit of using options to hedge is that losses from a market crash can be capped at a specific level, even while the fund is free to participate in a rising market. But the flip side of this strategy is that the fund incurs a cost in buying the hedge (which expires worthless if the market rises). Besides, the fund may participate only partially in a rally if the bull market continues. This strategy works well mainly with closed-end funds as the tenure of the put has to coincide with the holding period of the investor.